The Best Ways To Profit From Distressed Housing

The following story appears in the June 25, 2012 Investment Guide issue of Forbes Magazine.

Early last year Nicholas Vercollone bought his first property: a run-down three-family Victorian in the working-class Boston suburb of Chelsea for $175,000 in cash. The place, which he spotted on Zillow.com, was being sold “as is” by an estate. “There was two feet of snow in the living room, and we were working in raincoats through the spring,” chuckles Vercollone, a 32-year-old carpenter who decided to invest in distressed properties after working on renovations for other investors.

Fourteen months of near-daily labor and $375,000 in home improvement costs later, he put the updated units up for sale: $299,000 apiece for two three-bedroom condos and $270,000 for the two-bedroom third-floor unit. Like many young entrepreneurs, Vercollone financed the deal in part with loans from relatives (more on family lending here). After they, the Realtors and the tax collectors get paid, he figures that if he gets just 90% of his asking price for the units he’ll net up to $50,000.

Not great for a year’s work (he did odd jobs to support himself) but enough to convince him there’s money to be made in distressed residential real estate. Vercollone and his fiancée just snapped up a two-family house they plan to renovate and hold as a rental—the first of many they hope to own.

Since the housing bubble burst and the foreclosure wave began, nearly 4 million families have been pushed into the rental market. Meanwhile, the supply of habitable rental units has shrunk, what with new housing starts depressed and many foreclosed homes gone to ruin. The result: Rents are rising. The National Association of Realtors projects a 4% average increase in rents nationally this year and 4% in 2013.

So investors, ranging from large private equity funds to ­carpenter-entrepreneurs, are flocking to housing. The National Association of Realtors estimates investors accounted for 1.23 million home purchases, or 27% of sales, in 2011—up from 749,000 investment purchases, or 17% of sales, in 2010.

Today’s individual investors are a different breed from those who queued up in the early 2000s to buy new Tampa condos on credit, hoping to flip them for a quick profit. Last year half of investment purchases were for cash and half were of distressed properties. The median price paid was $100,000, up 6.4% from $94,000 in 2010. If buyers are planning to flip a property these days, it’s usually after fixing it up. And many are looking for a long-term, stable income play—something paying more than the 2% current yield on ten-year Treasurys.

Goldman Sachs economists estimate that rental properties (acquired at today’s prices) are yielding more than 6% on average nationwide. Even Warren Buffett lauds distressed single-family homes as an attractive investment now.

Tempted? Here are some pointers.

Getting dirty

“When investing in real estate the first question to ask yourself is ‘Do I want to get dirty?’” says Andrew Waite, publisher of Personal Real Estate Investor Magazine. If you have either building skills or a knack for managing contractors, you could pick up a cheap fixer-upper, rehab it and sell it or rent it out.

This is harder than it sounds, although the dearth of new construction means you can probably get quality workmen at reasonable rates in most markets. Vercollone suggests paying a general contractor $200 to $300 to walk through a property you’re serious about buying. (He did.) Take the contractor’s estimate, factor in other costs (taxes, marketing, etc.) and then add 20%, since something unexpected is sure to crop up.

“If you want to come in on budget and on schedule, you absolutely have to be a pessimist,” says Billy Procida, whose New Jersey real estate investment firm offers a Fix ’Em & Flip ’Em program. It lends up to 70% of the cost of buying and fixing a home, typically at 12% annual interest, then helps the borrower through the renovation process. (He can charge 12% because getting a bank loan for an investment fixer-upper is so tough.)

If you plan to keep the property and rent it out yourself, that, too, is at least a part-time job. But hiring a property manager could eat up as much as 10% of the rent.

The Clean-Hands Alternative

If you haven’t the time or temperament to supervise renovations or renters, consider “turnkey” property investing. Firms offering this service have popped up around the nation.

MACK Companies, for example, acquires bank-owned houses in the Chicago suburbs, renovates them and then sells them to individual investors for $130,000 to $160,000. It will even finance 60% of the purchase with a five-year balloon mortgage. Chief Executive James McClelland says properties are sold rented, with positive cash flow guaranteed for two years.

Steve Reifel, owner of Cost Containment Solutions, which audits communications bills for companies, just closed on his 11th MACK property, all financed with 20% to 25% down through a community bank (a better deal than MACK’s loans). “For me it’s a diversification strategy: I wanted something that could create more of an annuities-type stream that could offset my primary consulting business,” he says.

His houses are all rented out for $1,500 to $1,700 a month. He clears $475 to $525 per property, after expenses, including mortgage interest, taxes and an $85-a-month per-house management fee to MACK. “It’s not a get-rich-quick-type scheme,” says Reifel. “But these are actual homes that I can walk through and touch and see where my money is.”

Picking A Property

If you’re managing property yourself, you’ll need to stick close to home. But “you don’t want to be in just any market,” cautions Ingo Winzer, founder of Local Market Monitor, a Cary, N.C. firm that tracks housing data for 315 metro markets. The best bets: areas where prices appear to have bottomed and both jobs and population are growing.

Bone up on the capitalization rate: a measure of the rate of return on an investment property based on the expected annual rental income divided by the purchase price. A higher cap rate may come with higher risk, too. Example: Orlando, Fla. offers higher returns than Boston or Washington, D.C. But the future of Florida home prices is still iffy, so you might not be able to break even if you need to unload a property in five years.

Consider using a real estate agent who works directly with the banks. A good one should know how to handle the paperwork on a distressed deal and may have access to properties not yet listed publicly for sale. Check out foreclosure auctions and estate sales, too.

Don’t buy a property just because it’s cheap, McClelland warns. Instead, look for one likely to attract stable tenants. He favors four-bedroom single-family homes with two-car garages in neighborhoods with good schools and easy access to parks, shopping and downtown.

Taxes and Insurance

Becoming a landlord means new legal risks and tax complications. Form a limited liability company to hold your investment property; otherwise, your other assets could be at risk should an accident occur. If you’re not living in the house, you’ll need to pay for a “dwelling” insurance policy, which covers property damage, and a separate policy for liability.

An LLC is what’s known as a pass-through: All its income and deductions are passed through to your personal income tax return. It’s wise to hire a tax pro, at least at the start. But suffice it to say that after you finish claiming depreciation as well as out-of-pocket expenses, you’ll likely show a tax loss on your property, at least in the early years.

If you’re a “real estate professional” those losses are fully deductible against your other income—including a spouse’s salary. To qualify as a pro you must spend at least 750 hours per year and more than 50% of your working hours fixing or managing your properties. That’s tough to prove to the Internal Revenue Service if you also have a regular, full-time job.

If you’re not a pro? Then your losses are “passive” and normally deductible only against income from passive activities—say, other rentals or a partnership you don’t run. A special provision allows $25,000 of passive rental real estate losses to be deducted against nonpassive earnings like salary, but only if you and your spouse have adjusted gross income (not counting rental losses) of $100,000 or less. Above that, the break phases out. (Fortunately, any passive losses you can’t use while you own a property are allowed when you sell it.)

Still, direct investment in property offers the biggest potential returns. Buy at the right price in the right market and you can earn a hefty 8% to 12% return, plus appreciation. “Buying a property directly, that’s where your biggest potential gains would come,” says Tim MicKey of Monument Wealth Management in Alexandria, Va. “But it’s also where your potential biggest losses could come.”

I cover real estate, writing about everything from trends in the housing market to ultra high-end luxury listings to data-based cities lists. Real estate is in my blood thanks to a realtor for a mom and a property developer/landlord for a dad. I have had a front row seat for...